Markets Spring 2022
In the first quarter, the S&P 500 Index corrected intraday 14.9% from its high, and on a closing basis 13% implying that the U.S. economy is in a growth scare rather than an impending recession. By quarter end, a broad rally in stocks recovered more than half this correction losses. This was the worst correction since the start of the Covid pandemic two years ago. A faster tightening cycle by the Federal Reserve, runaway inflation and Russia’s invasion of Ukraine all contributed to the stock market’s correction.
The S&P 500 could retest current correction low if inflation does not peak in Q2. Parts of the Treasury yield curve inverted, typically a harbinger of a recession ahead. The yield curve subsequently quickly un-inverted to a positive sloping curve making an argument for growth ahead not a recession. The 3 months-to-10-years Treasury Yield Curve, a more reliable indicator, remains steep signaling no recession ahead. Which way the market goes depends on the path of inflation. If the Fed through its front-loaded hikes cannot curb inflation soon then expect a recession and down market in stocks over next twelve months. Furthermore, weighing on stocks is the upcoming Mid-term election. Historically stocks correct sometime from May through October period before Mid-term election.
The bottom line, this will be a transition year for the U.S. economy but worth the pain. Does anyone really expect that transitioning from abnormal monetary policy (zero Fed Funds rate in an economy that grew at 5.7%) to more normal monetary policy will happen smoothly? In the end the U.S. economy will be better off with normal yields and rates and so will income investors.
There may be room for investors to gain from stocks later this year. The S&P 500 typically peaks 18 months after an inversion and a recession typically starts shortly after that – late 2023. It takes around a year for stocks to peak after a point of the Yield Curve inverts, and the S&P 500 usually trades higher by 15% during that period, according to JPMorgan. Following the Midterm election, this November through April 2023, S&P 500 enters its historically best return period of the Presidential cycle, with past returns strongly positive one hundred percent of the time according to the Stock Trader’s Almanac. Given inflation recedes and U.S economy avoids a recession, stocks would rally. For the time being, I am only buying stocks at lower entry levels than today’s market level. I expect to be overweight stocks again before Midterm election day.
What lies ahead for the stock market? The S&P 500 should see above average volatility and extremely limited upside until after the Mid-term election. Research by Bespoke Investment Group shows that following corrections of 10% or greater and subsequent rallies of 10% or better, stocks rose in coming quarters.
Bear markets occur near the end of a tightening cycle and not at beginning. This tightening cycle began in March and ends in 2023. Valuations fall in advance of tightening into tightening cycle which explains why S&P 500 Index Price-to-Earnings (P/E) have fallen from 23 to 19 level over last 12 months. S&P 500 Index P/E is likely to fall further to a PE of 17 associated with inflation of 4-5% and in-line with slower growth. Of course, it could decline further depending on how far the Fed needs to tighten to cool down red hot inflation. My view is the S&P 500 Index peaked on January 3, however, after the Mid-term election it could be back on its way higher again. Inflation should head lower by year-end.
The Federal Funds rate (FFR) could reach 2.75% early next year according to CME Fed Watch. Inflation is running away, and unemployment is exceptionally low, so the Fed has room for front loaded hikes now. While these actions seem restrictive, after the Fed finishes with its tightening, interest rates will still be historically low. Modestly higher consumer rates will dampen consumer demand but not choke it to death. Remember, this tightening cycle is starting from an absurd FFR of zero!
I believe the economy and corporate profits will continue grow in 2022. The economy is healthy and employment picture is extremely strong. The economy is at the beginning of its Late cycle currently experiencing stagflation. The heavy damage from tightening cycle occurs late in cycle when curve flattens and inverts. There is a lag before higher rates slowdown the economy.
Earning (EPS) are growing but at a decelerating rate, and the same for sales. Analyst lowered EPS estimates for first quarter but raise EPS for remaining three quarters. Typically, the S&P 500 turns down 6-9 months before EPS turns down. Looking forward, Analyst are projecting earnings growth of 9.8%, and revenue growth of 9.5% for 2022 according to FactSet. The bottom line is that Analyst are optimistic on corporate sales and earnings despite of headline news of war in Ukraine, hot inflation, and faster tightening cycle.
Stocks do well during an inflationary period just not in high inflationary time. The S&P 500 EPS and Revenues have grown in an inflationary environment as long a profit margins hold either through productivity gains and or by companies increasing prices. Consumers are still buying goods at higher prices, like cars, fortified by their savings, high employment rate, and wage gains. However, at one point, inflation will generate demand destruction. Consumer will hold back on purchases if the price is too high. Analyst project revenue growth of 9.5% for 2022 which is above its 5-year average.
Most S&P 500 companies citing negative impact from labor cost. Even so the estimated net profit margin for the S&P 500 for Q1 2022 is 12.1%, which is above the 5-year average of 11.2% but below last quarter’s peak of 12.4%. The market has seen peak multiple and peak profit margins for this cycle. I just hope there is not a squeeze in profit margins because that would mean stock multiples further compress.
Earnings, sales, and profit-margins must hold up this year for market to trade higher. Inflation is the key to the market. Historically, when inflation has averaged 4-6% the multiple on the S&P 500 has been closer to a Price-to-Earnings ratio (PE) of 16.7 according to CFRA.
In the past conflicts like the Russian invasion of Ukraine do not have long term consequences for investors. Russia’s economy is one twentieth of the U.S. economy. Europe is a different story because its Green Policy makes it dependent upon Russian energy. Europe is at greater risk of falling into recession than the U.S., a country that can be independent of Russia oil if it chooses to do so. China’s lockdown of major manufacturing cities, in response to its latest COVID breakout, is disrupting the supply chain again and hurting consumption. For now, Europe and China are dragging down global growth and creating inflation pressure.